The Implementation of the Economic Value Added Methodology - Coursework Example

The Continuing Transformation of Asahi Glass: Implementing EVA – Case Study Table of Contents Introduction 3 Corporate governance in Asia 3 Attributes in Asia 3 The effect of main-bank based relationship 4 Strong supervision 4 Insurance provider 4 Cross-holding 4 Changes within the organization 5 The barriers to the reform 5 Rationales for reform 5 Implementation of EVA methodology 6 Evaluation of the EVA system 6 Conclusion and Recommendation 7 Reference List 8 Introduction This case study illustrates the implementation of economic value added (EVA) methodology at the Asahi Glass company which is a multinational organization, based in Japan, primarily engaged in the manufacturing of chemicals, flat glass, electronics as well as displays (Yahoo finance, 2014). EVA is one of those change mechanisms that has been initiated by the CEO of Asahi glass with an aim to transform the traditional Japanese company into a global firm. The other reforms brought about by the leader include a corporate reorganization into worldwide business groups, the appointment of non Japanese managers in crucial positions and reforms associated with corporate governance. The EVA methodology was implemented in order to improve resource allocation across Asahi Glass’s number of business around the world as well as to evaluate the managerial performance of top level executives (Mir and Seboui, 2008; Brown and Caylor, 2005). The case study explores the way the company calculated EVA and the weighted average cost of capital for the different business segments based in different countries (Desai, 2006). In this report we will analyze the impact of the bank based system on the company, the reforms associated with corporate governance, the barriers faced by the CEO while bringing about the reforms and lastly the implementation of the EVA methodology. Corporate governance in Asia Corporate governance framework constitutes of a bunch of mechanisms that are both market and institutional based which encourages the controllers of an organization to make decisions that are aimed towards maximizing the value of the shareholders. These mechanisms are meant to tackle agency problems. Normally, two basic models are utilized; control model that focuses on control from internal boards and market control that usually constitutes of independent boards, scattered ownership and policies that promotes transparency. It is however tough to determine the model that is the most appropriate one (Talamo, 2011; Handley-Schachler, Juleff and Paton, 2007; Thomsen, 2004). Attributes in Asia Corporate governance comprise of a variety of internal as well as external factors in companies such as Asahi glass. First of all, the ownership concentration in companies based in Asia is much higher than in companies based in the Western countries. This is precisely because majority of the big organizations in Asia are either family enterprises or state-owned. This results in the creation of an unequal and unfair selection system. This type of governance framework existing in organizations might have had lots of advantages such as companies belonging to the same group could borrow money from one another and operate with a elevated gearing ratio. However, this framework also had its fair share of flaws. For example organizations that followed this framework had low efficiency, low return on invested capital and high risk of failure. Secondly, investors in these kinds of companies are not interested to contribute towards improving the performance. Once they realize that the share prices are falling they choose to sell them. However, on the other hand some bog debtors take necessary steps in order to ensure the improvement of the corporate governance framework. In the case of Asahi Glass, such has been done by the main-bank which will be discussed in the following section. The effect of main-bank based relationship Firstly, the main-bank of a company refers to a bank that shares common interest with the company. This is precisely because the bank is the largest lender to the company and is amongst the majority shareholders through the arrangement of cross-shareholding. The main-bank also shares a broad trading relationship with the company that includes lending loans, providing currency exchange services as well deposit services to the company. Majority of the organizations in Japan have a minimum of one main-bank. It is the same in case of Asahi Glass as well. The impact of having such a relationship on the company is as follows: Strong supervision Being the largest shareholder of and lender to the company, the main-bank reserves the discretionary power to do a methodical administration of operations conducted within the company. With the resources available to the bank as well as well as the interpersonal relationship that it shares with the firm enables the entity to execute a more efficient, effective and consistent administration as well as provide consultancy that can be of huge worth to the corporate governance framework of the firm. Even, the senior managers working for the main bank can be assigned to work with the company’s management in order to have an undeviating influence on the company’s decision making process. Insurance provider Main-banks could be of great help in a floating-interest rate system by facilitating even cash flows to and from the company thereby lending at floating rate of interest. Especially in case of mutual agreement, where the company attains high profit, the banks could charge the company high rate of interest and in the event of failure they can charge lower interest rates. Under such a system, a company can manage to tackle the financial disputes with the support of a floating interest rate system. Cross-holding In the event that the company’s shares are cross-held by the bank, identity chaos might be the end result. On the one hand, the bank, as a shareholder, might be so worried about the company’s future expansion plans it might invest a lot of money without paying much attention to the risk associated with such hefty lending. Alternatively, if the bank is too worried about the company’s risk of defaulting, it might refrain from lending to the organization. Changes within the organization The barriers to the reform The reforms surround both the management as well as other functional departments of the company. In the top (management) level, Asahi Glass appointed two directors external to the company in order to be able to supervise the management. Board meeting is organized every month where the centre of discussion is the strategies set forward by the president. In addition to that, the executive progression procedure is supervised by a nominating committee comprising of four people that is established by the company itself. In the departmental level, the department of finance is assigned with the responsibility of optimizing the cost structure for the company thereby reorganizing the insurance and tax management. The department of human resource is assigned with the responsibility of recruiting qualified employees who are non-Japanese in key positions within the senior level. This is a very prudent step if the advent of globalization is taken into consideration. In order to be able to do so, the EVA methodology has been implemented by the company which will be illustrated in the sections to follow. However, there are certain barriers to the reform which are: Conflict between the former members of the board as the reform withdraws the right from majority of them. Pressure created by the management that comprise of domestic employees. The company involves many foreigners who are working in the management level. Hence, conflicts can arise between them because of the fact that they belong from dissimilar cultural backdrop. Customary mindset of the existing employees and their doubts regarding the new reform can be a barrier if they find it hard to accept the changes. They may misunderstand or misinterpret the reforms because of which they might find it hard to adapt to them as a result of which conflicts may escalate (Desai, Egawa and Wang, 2004). Rationales for reform The reasons behind the reform are that Asahi Glass Company has grown considerably and it manages numerous branch companies. The company has to pay attention towards the fundamental strategies and assign the branch company with the responsibility to mitigate the risk. Another reason behind restructuring is that appointing numerous board members might not be efficient. Rather, the appointment of an independent director looks professional and brings a new style of thinking. Moreover, Asahi Glass has become globalized and thus it cannot be controlled by the internal board. Therefore with the responsibility assigned to the branch companies, they will have to recruit number of foreigners, which also makes it necessary for the company to become accustomed to international business environment. Implementation of EVA methodology Implementing an EVA system requires accurate data regarding NOPAT, Capital Employed (CE), as well as WACC. The formula is: EVA= NOPAT- CE* WACC. Ideally CE and NOPAT can be calculated exactly; however WACC calculation can be challenging. Diverse choices of Market Premium, Risk-free Rate and Beta give different results (Savarese, 2000; Grant, 2003; Das and Pramanik, 2009). The case-study illustrates that: “About 1,400 lower level managers in Japan were evaluated based on the absolute EVA calculated using a WACC of 5%, which was based on the cost of capital in Japan in 1999. They planned to use 8% for the lower level managers as well starting 2004.” (Desai, Egawa and Wang, 2004, p. 9). This however is not an ideal way to implement EVA because dissimilar organizations have different values of WACC. Also in companies with sub-branches, WACC is different in every single branches. Thus, applying a single value for WACC is not right. Moreover, EVA system is associated with certain drawbacks even after that it is a good means of measuring performance. Evaluation of the EVA system The EVA methodology used by Asahi Glass is inappropriate because of the reasons mentioned as follows: 1. The primary flaw is the way WACC is considered for every country.   Cost of debt: The risk of defaulting gives the actual weighted average cost of debt.  Risk is sub-divided into unsystematic risk and systematic risk.  The risks that are connected to the market is the systematic risk. In this particular case, the systematic risk is the risk free rate for each country.   I. Industrialized countries Asahi Glass takes into account systematic risk only by including a predefined spread to each country’s risk free rate. This is illogical because unsystematic risk has not been considered. Moreover, the risk of defaulting in an operation depend heavily over unsystematic risk, that is defined by factors like operational risk, economic risk, financial risk, business risk, market risk, industry risk as well as other factors. II. Emerging countries The computation is illogical because of the very same reasons mentioned above. It takes into account only systematic risk. Cost of equity: The factor Cost of equity experience the same problem of not taking into account unsystematic risks of the operations conducted in various industries. 2. Formula for calculating EVA EVA = (NOPAT – CE) x WACC ------------------------- (equation 1) a) If the calculation of WACC suffers from the same problem of not taking into account the unsystematic risks associated with the operations in different countries, the computation of EVA is illogical too (Savarese, 2000; Grant, 2003; Das and Pramanik, 2009). For example a company’s business operation (Department D1) is allocated a 10% WACC. Another segment (D2-panel display business) of its business has been allocated a 7.2% WACC.  A third department (D3-flat glass) of the company is allocated a greater WACC because its operations spans over emerging countries like Indonesia, Thailand and China. The second department is assigned with the lowest WACC (7.2%) due to the fact that the countries in which it operates have lesser WACC input.  However, the panel display business is associated with greater unsystematic risk because of the nature of the operations. The business that manufactures flat glass entails risk due to the maturity of the industry and longer life cycle of the product. The different levels of risk can be explained by the instability of operating profit. The Flat glass business’s operating profit is very less unstable compared to the panel display business (Desai, Egawa and Wang, 2004).   Conclusion and Recommendation For Asahi Glass, implementing EVA for allocating resources might not be appropriate and is very dangerous as it does not consider the WACC properly. If they do implement this methodology, then it might result in an over allocation of resources in departments which are risky and under allocation of resources in departments which are less risky. In addition to that, implementing EVA for the purpose of management compensation is unjust because the managers are awarded for taking greater risk instead of being rewarded for hard work. It is strongly suggested that Asahi glass should take risk specific to operations into consideration while determining WACC. Reference List Brown, L. D. and Caylor, M. L. 2005. Corporate governance and firm performance. The Accounting Review, 80(2), pp. 423-440. Das, B. and Pramanik, A. K., 2009. Economic value added. Delhi: Deep and Deep Publications. Desai, M. A. Egawa, M. and Wang, Y., 2004. Continuing Transformation of Asahi Glass: Implementing EVA. Harvard Business Review, pp. 1-29. Desai, M. A., 2006. International Finance: A Casebook. New Jersey: Wiley. Grant, J. L., 2003. Foundations of Economic Value Added. New Jersey: John Wiley & Sons. Handley-Schachler, M., Juleff, L. and Paton, C., 2007. Corporate governance in the financial services sector. Corporate Governance, 7(5), pp. 623-634. Mir, A. E. and Seboui, S., 2008. Corporate governance and the relationship between EVA and created shareholder value. Corporate Governance. 8(1), pp. 46-58. Savarese, C., 2000. Economic Value Added: The Practitioners Guide to a Measurement and Management Framework. NSW: Allen and Unwin. Talamo, G., 2011. Corporate governance and capital flows. Corporate Governance, 11(3), pp. 228-243. Thomsen, S., 2004. Corporate values and corporate governance. Corporate Governance, 4(4), pp. 29-46. Yahoo finance, 2014. Business Summary. [online] Available at: [Accessed 14 February 2014]. Read More